Germany: The Reform Of The German Investment Tax Act

On 8 July 2016, the German Investment Tax Reform Act passed the
Federal Council of Germany. As a consequence, the act will
basically take effect on 1 January 2018 with a wide-ranging impact
on the taxation of income realised through an investment fund. The
reform implies a significant challenge for Asset Managers but also
present new opportunities to gain additional market shares. Now is
the right time to focus on the reform and to take action in order
to make the most of the new legal environment.

Basic content of the reform

The reform fundamentally changes the taxation of investment
income by introducing two separate taxation systems for investment
funds on the one hand and special investment funds on the other
hand. While an opaque taxation system will apply to investment
funds where both the fund and its investors are subject to tax, the
principle of tax transparency can be continued for special
investment funds with however fundamental modifications.

Scope of application

The reformed German Investment Tax Act ("GITA 2018")
is applicable to investment funds which are defined as investment
asset pools within the meaning of the German Capital Investment
Code. In addition, so-called "fictitious investment
funds" are in scope of the GITA 2018 even though they do not
qualify as investment asset pools. In practice, the most relevant
case from a practical point of view will be so-called single
investor funds, i.e. investment vehicles which limit the number of
possible investors to one single investor but are in line with the
remaining requirements for an investment asset pool. Furthermore, a
company which must not unfold an active entrepreneurial activity
under the laws of its home country and which is not subject to tax
or exempted from tax will be deemed an investment fund.

The GITA 2018 is not applicable in the following cases:
" If the certain exceptions of the German Capital
Investment Code are applicable (e.g. securitisation special purpose
vehicles and holding companies)

If the investment asset pool is
established in the legal form of a partnership, provided that it
does not qualify as UCITS; investment funds of a contractual type
(Sondervermögen) are however not considered to be
partnerships

In the case of participation
companies pursuant to the German Participation Companies Act and
REITs which are subject to the German Real Estate Investment Trust
Act

In order to qualify as a special investment fund, an investment
fund must comply with certain additional requirements which are
comparable to the criteria to be fulfilled by all types of
investment funds under the law currently in force. In other words,
those requirements relate to regulation, redemption rights,
eligible assets and investment limits. In addition, the number of
investors must not exceed 100 whereby private individuals are
basically prohibited. Unlike under the current rules, individual
investors may however invest even directly into a special
investment fund if they hold the fund units as part of their
business assets. On the other hand, a look-through approach in
relation to partnerships as investors will take place resulting in
the fact that private individuals can basically no longer invest
indirectly into a special investment fund.

It will be important to cope with the new requirements of a
special investment fund already before 1 January 2018 given that a
change from an investment fund to a special investment fund is
excluded after that date.

Investment funds

One of the key points of the GITA 2018 is that investment funds
will be subject to German corporate tax to the extent they receive
German sourced dividend and rental income as well as capital gains
from German real estate. These items are fully taxable at a rate of
15% including solidarity surcharge in the case of income subject to
German withholding tax. In the case of income where no deduction
took place, i.e. where the investment fund needs to file a
corporate tax return with the German fiscal authorities, the tax
rate amounts to 15% plus solidarity surcharge thereon. All other
income (e.g. interest income, capital gains from the sale of stocks
and other securities) is tax-free.

An application for exemption from corporate tax is possible to
the extent that certain eligible investors are invested in the
investment fund. Also, an entire exemption from corporate tax is
possible if the constitutive documents of the investment fund
necessitate that only certain eligible investors must hold a
participation.

Finally, German trade tax may become due at the level of the
investment fund. An exemption does however apply if the objective
business purpose is limited to the investment and management of the
assets for the joint account of the investors and if an active
entrepreneurial management of the assets to a substantial extent is
excluded.

In addition to the investment fund, also the investor is subject
to tax based on a very generalising system. Under the GITA 2018,
the following items will trigger a taxation:

Distributions regardless of their
composition (e.g. even a repayment of capital will be taxable)

Pre-determined tax bases

Capital gains realized upon the
disposal of investment fund units

The objective of the pre-determined tax base is to make sure
that at least the risk-free market yield is taxed in the hands of
the investors. It is therefore due if the distributions remain
under the so-called base proceed. The base proceed in turn has to
be determined by multiplying the first redemption price set in the
calendar year with 70% of the base interest rate (long-term yield
on public bonds published by the German Central Bank). The base
proceed is capped by the actual increase in value of the investment
fund unit plus any distributions. The pre-determined tax base is
then deemed to be received by the investor on the first business
day of the following calendar year.

Any investment income (distributions, pre-determined tax bases
and capital gains from the disposal of investment fund units) can
generally be subject to a partial exemption provided that the
respective investment fund qualifies as equity fund, mixed fund or
real estate fund:

equity funds are investment funds
that invest continuously at least 51% of their value in equity
participations according to their constitutive documents. The
partial exemption amounts to 30% for private individuals. For
individuals holding the investment fund units as part of their
business assets, the partial exemption increases to 60%. For
corporate investors, 80% of the investment proceeds are
tax-free.

mixed funds are investment funds that
invest continuously at least 25% of their value in equity
participations according to their constitutive documents. In this
case, half of the partial exemption rates applicable to equity
funds is available.

real estate funds are investment
funds that invest continuously at least 51% of their value in real
estate and real estate companies according to their constitutive
documents. The partial exemption rate amounts to 60%. If the
relevant investments are made in non-German real estate and
non-German real estate companies, the partial exemption rate
increases to 80%.

Special investment funds

On principle, special investment funds are subject to German
corporate tax to the same extent like investment funds. They can
however opt for tax transparency, i.e. the tax system known under
the prevailing law can be continued depending on the choice of the
special investment fund. In other words, the tax liability is
dropped and the income of the special investment fund is deemed to
be received directly by the investors. It should though be noted
that significant amendments have been made to the principle of tax
transparency.

As under the current GITA, investors are taxed on distributed
income, deemed distributed income and on capital gains from the
disposal of special investment fund units. The modifications
mentioned above primarily concern the determination of the income
at the level of the special investment fund and the attribution to
the investor:

The income needs to be grouped
depending on the tax effects at the level of the respective
investor;

with regard to distributed income, a
new distribution order is to be taken into account;

the equalisation methodology will not
be accepted for tax purposes any longer; instead, an attribution of
income and expenses to the investor on a pro rata temporis basis
takes place:

in the case of a distribution of
income which has been generated during a time period where the
investor was not invested in the special investment fund, a
repayment of capital is simulated

in the case of a reinvestment, only
income and expenses actually generated during the holding period of
the investor are attributed to that investor; in addition, the
income is deemed to be received by the investor at the end of the
fiscal year of the special investment fund regardless of a prior
sale of the special investment fund units

The extent of the deemed distributed
income has been newly defined, i.e. inter alia it does not include
capital gains from the sale of bonds whereby a distinction between
DDI-bonds and plain vanilla bonds is not necessary any longer; an
exception only applies in the case of swap contracts to the extent
that the swapped payment flows are determined by dividend or
interest income;

Any income which is not part of the
deemed distributed income is deemed to be distributed with the
expiration of the fifteenths fiscal year of the special investment
funds following the collection.

Transitional rules

The GITA 2018 will basically enter into force on 1 January 2018
regardless of the fiscal year of the investment fund and of the
acquisition date of the investment fund units. Investment funds
with a fiscal year differing from the calendar year have to form a
short fiscal year as per 31 December 2017 for tax purposes.

Investment fund units, units in corporate investment companies
and in investment vehicles falling into the scope of the GITA 2018
on 1 January 2018 for the first time are deemed to be sold on 31
December 2017 and re-acquired on 1 January 2018. The capital gain
will however only be taxed at the time of the actual disposal of
the units.

Investment fund units acquired before 2009 are currently
grandfathered in such a way that capital gains are not taxable.
This protection will end on 1 January 2018, i.e. any changes in
value taking place from that date onwards will become taxable to
the extent they exceed a tax exempt amount of €100,000.

Impact for Asset Managers

The GITA 2018 will completely change the way of how investment
income is taxed and particularly Asset Managers should undertake
immediate action in order to prevent outflow of funds. Particularly
business investors are balancing pros and cons at the moment
regarding the question whether they should shift their investments
from investment funds to special investment funds.

As far as investment funds are concerned, the main points are
that Asset Managers need to make sure that the fund is taxed
correctly in Germany which may include the filing of corporate tax
returns. Equally, it may be necessary to re-structure investment
funds in order to avoid any tax disadvantages for the fund as well
as for its German investors. This includes amendments to the
constitutive documents as well as an appropriate flow of
information and communication. Finally, an adequate management of
withholding taxes is vital to remain competitive and processes need
to be implemented for the purpose of benefitting from a partial or
even full exemption from German corporate tax in the case of
eligible investors.

In relation to special investment funds, the challenges go even
beyond. In particular, Asset Manager should engage themselves with
the question whether or not it is necessary to launch special
investment funds specifically for the German market in order to
retain their German business investors. The usual business where an
investment fund is structured in such a way that the units can be
distributed on a cross-border basis will not work any longer due to
the specific requirements of the GITA 2018. In the case a special
investment fund has been founded, the new provisions dealing with
the determination of the income means an enormous challenge for
Asset Managers.

This particularly holds true with respect to the attribution of
income and expenses on a pro rata temporis basis as a result of the
omission of the equalization method for German tax purposes.
Broadly speaking, the new investor reporting will no longer follow
a "one-size-fits-all- approach". Instead, the reporting
need to be individualised taking into account the specific position
of each and every investor.

To the
point

On 8 July 2016, the German Investment Tax Reform Act passed the
Federal Council of Germany. As a consequence, it will basically
take effect on 1 January 2018 with a wide-ranging impact on the
taxation of income realised through an investment fund

The reform implies a significant challenge for Asset Managers
but also present new opportunities to gain additional market
shares. Now is the time to concentrate on the reform and to take
action in order to make the most of the new legal environment

For investment funds, the principle of tax transparency will be
dropped resulting in the fact that both the fund and its investors
will be subject to German tax

By way of contrast, special investment funds can opt for tax
transparency meaning that the taxation known under the prevailing
law can be continued; the legal modifications are however
significant

Asset Managers need to make sure that the investment fund is
taxed correctly in Germany which may include the filing of
corporate tax returns. Furthermore, care has to be taken that
investment funds are optimised from a German tax perspective, that
withholding taxes are managed in the most efficient way and that
processes are implemented in order to benefit from a potential
exemption from German corporate tax

As far as special investment funds are concerned, Asset Manager
should consider to establish special investment funds exclusively
for the German market in order to retain German business investors.
The complexity of the investor tax reporting will increase
considerably, because it needs to be individualised taking into
account the specific position of each and every investor

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.

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